The old adage has it that Ownership is nine-tenths of the law, for many Chinese companies we can flip that around to nine-tenths of ownership is legal entities, and there are an awful lot of those. We touched on this last week in our post on Huawei’s ostensibly spun-off handset business Honor, but two recent academic papers drive the point home further.

The first is a paper written by a Chinese academic Wang Jun looking at the ownership of Huawei. This is a link to the original post in Chinese (Google Translate does a decent job with it), and this is a good write-up on the paper from a Xinhua reporter (who writes a solid blog, but read it with radar set to high given his employer). The author is writing in response to a paper published by American academic Chris Balding who has become infamous among China watchers for some of his claims (this is a whole other topic, but again read this paper too with radar set equally high).

This is an important topic. Huawei’s ownership is famously opaque. The company claims that it is owned by its employees through a worker’s union. So the question becomes who controls the union. Balding claims that the shares are effectively controlled by the Chinese State. Wang’s paper takes apart that claim with a rigorous study of Chinese corporate law, and its evolution over the past 30 years. The super summary of both papers, in our view, is that neither really answers the question. The American paper has a fair amount of unsupported claims, while the Chinese paper elides the key question of control. The US government claims that the Chinese state controls Huawei, with a lot of rumors that it is the People’s Liberation Army specifically holding the reins. Ultimately, we have no way of knowing the answer, but there is a distinct lack of clarity on this question, enough to merit attention. For our purposes here, the main point is that ownership of Huawei is incredibly complex.

The second paper is from Bai, Hsieh, Song & Wong published by the University of Chicago. This takes a systematic look at 30 years of ownership data of all Chinese companies and concludes that connections to the Chinese state have increased pretty noticeably over this period. Crucially, they define connection as ownership by state entities or investment funds backed by the state. This paper resonated with it as we have encountered this first hand in our work dealing with Chinese private equity funds investing in semiconductors. The Chinese government has been promoting investment in semiconductors, but it does so largely through this investment firms which are largely staffed by experienced semis executives.

An overarching theme of the paper is that this increase in state connections came largely in the form of investment into private companies, even going so far to show that these companies see increased growth in the years following their “connection” to the state entities. However, for us, the most interesting aspect of the paper are the details of the complex ownership structure of companies with multiple tiers of holding companies sitting several layers on top of the productive assets. Even the simplest ownership structures are mandalas of flow charts with arrows and dotted lines. This line from the conclusion really jumped out:

In 2019 this hierarchical chain extends to owners that are more than ten steps away from the
state owners.

That is to say, there can be at least ten levels of entities between the ultimate owners and the underlying company. We know that Western multi-national corporations employ some complex corporate structures, often for tax “optimization”, but the only US company we know that ever approached this level of complexity was Enron.

Two years ago we worked with a client who wanted to trace the ownership of one of their Chinese customers. We quickly ran into a brick wall tracing the ownership structures within China. We were able to pull down data on some of this company’s overseas subsidiaries. We found that in one market, a key target for their exports, the Chinese company had twelve subsidiaries that we could identify (and we believed there were several more we could not find). Each of these companies had entirely discreet directors, that is of the roughly 60 people named in the registration documents none worked for more than one of the twelve entities. In turn, each of these entities was owned by another set of entirely non-overlapping companies in other countries (i.e. not the target country and not China), and none of the representatives of those companies overlapped with any of the other companies on the list. Given that the parent company had operations in close to 100 countries, and we believed that those all had equally complex corporate structures, we had to stand back in awe. The sheer amount of management overhead required to keep track of what had to be hundreds if not thousands of corporate entities is a pretty monumental task. (We always imagined there was some low-level administrative employee back in headquarters in Guangdong keeping track of all of this with an Excel spreadsheet that was impossible to read.)

All that being said, we think two things are worth keeping in mind. First, there are all kinds of legitimate reasons why Chinese companies have these complex organization structures. That is the real point of Wang’s paper. China’s corporate law has changed dramatically since the 1980’s. These changes have generally been an improvement, but companies have had to adapt to those changes along some fairly convoluted paths.

Second, this has mixed implications for foreign companies working with or competing against them. On the one hand, all this complex structuring is messy and very likely open to abuses. Many Americans we have worked with assume these corporate shell game are bordering on criminal conspiracy, but the reality is much more mundane. Westerners may believe the structuring is done to avoid laws and regulations, conferring an unfair trade advantage. We think the opposite is true. There is no reason to assume that these structures are an advantage for any of these companies. Chinese companies are burdened with ownership structures that create a whole basket of mixed incentives and this adds immense internal friction. Put simply, would you rather compete against a nimble start-up founded with a set of Stripe Atlas corporate papers or a massive bureaucracy that has to spend real effort just keeping track of all its constituent parts? As much as it is fashionable today to bemoan China’s state-backed initiatives to expand exports and capture technology, US companies should see those as working in their advantage, anchoring their competitors to rigid corporate structures.

Photo credit “It’s Always Sunny in Philadelphia”